Why a detailed analysis of balance sheet strength can be key to identifying attractive opportunities.
Andy: Balance sheet strength and financial soundness is paramount to what we are doing here.
When we’re looking at balance sheets, we try to focus on gross and net debt to EBITDA. In that regard we’re trying to think like credit analysts. And our goal here is to ensure that (A) companies will be able to service their debts without issue and (B) that really servicing the debt is not going to be a focus of the company, that it's a minor concern. They’re going to instead be focused on operations of the business.
M&A is something that we analyze very carefully.
Brad: Most small-cap stocks they get on this M&A treadmill. They do a deal or two. They put debt on their balance sheet, it becomes permanent because they don't have the free cash flow generation, or the business strategy, or the discipline to pay down that debt in relatively short order.
We like to invest in companies that have a manageable amount of leverage and oftentimes we will invest in companies that do have debt.
But there must be a catalyst which is reflected in an inflection free cash flow generation, which will lead to a subsequent deleverage in the balance sheet.
Or a company that may have a noncore asset, they’re desiring to sell which will also lead to a significant deleverage in the balance sheet in a reasonably short period of time.
Andy: In simplistic terms we try to think of small caps as containing two big risks. We think of financial risk and operational risk. Operational risk is really hard to avoid in small caps. They generally lack scale, they have smaller management teams, less bandwidth in the management teams, and for that reason operational risk is something that we cannot avoid.
Brad: On the other hand, financial risk is associated with companies that have leverage. Lots of debt can cause operating risks to be very high in a company and that’s a risk we do not like to take.